Attention: If you are an entrepreneur who has a fat startup, which has the potential to be the defining investment in an investment portfolio (10–30X return)- even if a large portion of the other companies fail, then you are VC material and in the 1% club.
In that case, don’t waste your time reading further. I suggest reading a post by Linus Dahg. This post is for the other 99% of entrepreneurs who are not in that club.
Your choice of partners — be it a life partner, co-founder, management team, investors, or board members — is the most critical decision you will make. Unfortunately, most entrepreneurs do not choose with the diligence it deserves. My interest here is solely on your relationship with an investor at the seed stage. Caveat emptor!
Early Stage Investment Conditions
Asymmetry of Power: You are desperate for money and are very vulnerable. It is not a transaction on an equal footing. You can easily be taken advantage of. Unless, of course, you have other options and can be choosy. The very best advice anyone can give you is- Get to a position of strength before seeking money. In a desperate situation, you are going to be taken advantage of.
There are “Good” Investors, but You Probably will Not Get To Them: Of course, there are “good,” supportive and ethical investors. Ethics is not uniformly distributed. There are very credible VC’s. But, you will not get a meeting with them, let alone money. You do not fit their criteria. Today everybody and his Uncle can open an investor shop. God knows who you will get.
The chances are that without thorough due diligence and reference checks on your part, you will get one of the not so good ones. What is their track record? What do the other investees say about them in private? You need to check them out as much as they check you out. The more desperate you are, the worse ones you will get.
VC’s Invest in < 1% of the Deals But Pollute the Other 99%: VC terms are designed and written for the eventual IPO within a short period of time. As such, they contain many clauses to protect the VC.
They assess the company's quality by looking at several factors. Some of the important bits are; revenue potential, total addressable market (TAM), how fast it can grow (i.e., scalability) and profitability potential, etc.
The irony is that VC’s invest in less than 1% of all entrepreneurial ventures. Their economy dictates that the company can be the defining investment in an investment portfolio (10–30X return)- even if a large portion of the other companies fail.
This is a very stringent criterion, and they are willing to support the companies that pass that muster. Yet, their criteria and their way of doing business have permeated almost all the other 99% investors. Seed-level investment groups need to be called out for special mention on this score.
VCs go to conferences, and if one of them has come up with a genius way of protecting themself, then the next morning, all of them add that clause to their overloaded term sheet. And a week later, all “investors” are clamoring for the same.
The net of all these “sophisticated investor terms,” often copied from VC term sheets, contains many adversarial “prenups” that asymmetrically puts the entrepreneur at a disadvantage. This is especially true if you present large “venture-style” outcomes to raise capital from non-VCs — e.g., angels, corporate strategic investors, and other non-VC institutions. If you are not VC material, do not waste your time chasing them and look for those offending “prenups.”
Seed Level ROI is Not Considered Attractive Enough: Other than a few hot spots on the coasts, the growth of new ventures overall has declined substantially in recent decades. This is primarily due to the paucity of seed level capital. Cities like Minneapolis and Milwaukee (home of mega businesses) suck, on that score, while there is growth in spots like Beijing, Stockholm, Bangalore, etc. Support for seed level investment, while seemingly greatly increased, is still at pathetic levels. The purported reason is that the ROI at the seed level is not attractive enough. I know of at least one seed level investment group that returned all their capital raised because the return at the seed level was not attractive enough. I believe you hold the key to turn it around (see Your Alternatives).
Investor Models Require More Maturity: Investors are looking for high-quality seedlings (a Series A or later offering) to shower them with support. Meanwhile, they are expecting seeds will magically sprout into seedlings. Go figure! If you insist on going at the seed stage, they will insert toxic terms at the Early Stage. One way or another, the onus is on you.
Misalignment of Terms
Most Investors and Entrepreneurs have Not Aligned: The investor and entrepreneur relationship is like a business marriage that should last a long time. It should be based upon aligned goals and reason to love each other. Unfortunately, it is most often like a hastily arranged marriage. At startup, entrepreneurs, eager for cash, often put their venture's long-term vision at risk to get the investor to participate. Investors may have various objectives in mind when they invest, including financial returns, passion for the business, or impression of the team. However, it is not uncommon that the investors’ motivations diverge from founders’, and it is a marriage made in hell. Take time to find the right partner.
Other than pure fraud, here are many other ways that the investor can be in bad misalignment:
Misaligned Structure: Most funding is done either through “preferred shares” or through “convertible debt” structures, while entrepreneurs and employees usually hold common stock. Since Common stockholders are on the bottom of the priority ladder, Preferred stockholders have a higher claim on the assets and earnings. A fire sale and/or bankruptcy can often be in the interest of debtors or preferred shareholders, while it is harmful to the common shareholders. Often you focus on valuation rather than on investment structure and can be trapped by seeming better valuations. I heard an Investment Banker boast once that “If the venture is not in default on the day they sign the contract, we didn’t negotiate well.” That was his way of reigning in the Cowboys. Be very careful of the structure. Resist exotic instruments whose performance you cannot predict.
Follow on Money: If your startup has a down round or needs a bridge round on unfavorable terms, then you will be the one who gets crammed down. Silicone Valley had a great episode on why getting a high valuation early on is a kiss of death. This is particularly true with “anti-dilution” clauses. Do not be fooled or tempted by overvaluation at the beginning.
Timeline: Funds usually have an investing period of five years and a harvesting period of 2–5 years. If it is the end of the fund’s life, and the investor wants to sell, you have to exit prematurely. What is the investor's time frame, and does it really give you enough time to build what you want?
Speed and Scalability: Most investor models, based on VC criteria require a rapid growth rate, even at the expense of a lot of investment in Marketing and Sales. If your venture needs a slower pace to ramp up or research time, you may end up pushing it too fast. Just think of a Bicycle being driven at the speed of a Ferrari. What do you think will happen? A crash is assured. Be realistic in your time frame and allow for unexpected delays. Please don’t push it faster than the natural rhythm.
Stealth Terms: To make the deal, the investor will often offer a high (even ridiculous) valuation to tempt you. But, they will put in some “usual and customary” terms that don’t mean much to you now. However, you will realize that you have been screwed down the road. This is a long topic in itself, but for those interested, I refer to a presentation by Charley Grady Caveat Emptor: Bullet Proof Your Enterprise on the 10 common stealth terms.
Greed and fear are the two tools that investors will often use to trap you. “Greed is Good” works for Gordon Gekko, not you.
Misaligned Skills: Look at the Investor portfolio people who are going to be “looking after” your venture. In most cases, the person would know less about the business than you. They may be fresh graduates from a top college with limited, to no, day-to-day experience running a venture. And they probably do not know the people, customers, partners, and the markets as well as you. They often have a greater knowledge of financial models. As we all know, it is one thing to generate a proforma on an Excel sheet and quite another to do so in the marketplace. Plus, in the ever-changing market, the Excel sheet takes minutes and a lifetime in reality. Who will be your handler, and what can you expect from hir?
Vanishing Value Add: The investor often talks about “value add,” about the relevant skills, connections, and reputation that the investor provides your company. Value add is important, but it isn’t everything. In any case, the value is overrated. Vinod Khosla, the founder of Khosla Ventures, said that 70% to 80% of VCs add negative value at a TechCrunch event. According to him, most VCs “haven’t done shit” to know what to tell startups going through difficult times. A less than stellar VC investor would have done even less than shit.
Lucky Third Tier Early Employee of a Unicorn: The worst investor is the one who got lucky and made a bundle by being an early second or third-tier employee of Google (or Facebook, Twitter) and now portray themselves as “experts” by throwing the name and weight of their Unicorn. Their knowledge base is still of a second-tier employee. To hide their inadequacy, they will act as a bigger SOB. In some cases, they invest in small-outcome-oriented founders businesses expecting VC type metrics. Don’t get enamored by making money and finding out their experience.
Your Advisers are Often Aligned with the Investor: The most common advice given to the entrepreneur is to get the relationship started on the right foot. Check it out. Who is giving that advice? The chances are that the consultant ( in print, columns, personal discussions) has an alignment (hidden or overt) with the buy-side. Are you getting the best advice with that “conflict of interest”? Who is your adviser on these matters, and which side is his bread buttered?
Misalignment of Mission and Values. You are afraid to share the real reason for doing what you are doing. Your concern is that the only thing of interest to the investor is money. So you dress up the whole thing accordingly. Unfortunately, as General Helmuth von Moltke noted, “no battle plan ever survives contact with the enemy.” In execution, the plan frays, and the woes begin. To feel comfortable dealing with the person for a long time, you have to share the situation, warts, and honesty.
Lack of Clarity on End Goals: One of the common misalignment is the “exit” strategy. The investor is entitled to know how they will get their money back. You want to pass it on to your children. Without a commonality of agreement, it can be a huge conflict source. Are you in alignment?
Investor a Real Partner or Merely a Rapist:
While everyone knows that a new venture is risky, the terms often drafted in the investor agreement are such that any negative consequence in the future is squarely placed on the entrepreneur's shoulders. You intended to marry them “from this day forward, for better, for worse, for richer, for poorer, in sickness and in health.” Marriage is never an easy relationship. There is an early honeymoon period; shortly after an investment is made, everyone is happy and excited. But then the real difficulties come.
You often find a rapist whose sole purpose is carnal gratification, with no regard for you.
Unfortunately, that is an outcome that happens more than it should because entrepreneurs have a very romantic view of investments and ventures and fall into a trap without thorough thought and exploring alternatives. They are like a teenage boy who thinks anyone who smiles at them is in love with them.
If you are interested in a lean start-up, I suggest you look at ways to do one of the following from Idea to an MVP, in order of my preference:
- BootStrap: The further developed your idea is to a viable product, you can negotiate better terms from a strong position. Look for ways of doing it. Do not automatically assume that it is out of the realm of possibility.
- Reduce the Cash Outlay and Follow the Process to Increase Probability of Success: If you set that as a goal, I have several examples of entrepreneurs being able to reach an MVP with only a 40% cash outlay of Normal. Of course, the rest is equity to team members and internal supporters. You can improve the probability of success by following the process, even if it is a modest %. Do the Math for two alternatives: a) $40K investment with 20% success probability vs. b) $100K with 10% probability of success. Both reach the same MVP. You will see how attractive the ROI becomes at the seed level for the first alternative—Bootstrap the 40% cash outlay.
- F & F: Same as # 2 with 405 investment coming from F&F and supporters. Caution: still disclose Investor type caveats even if they are F&F.
- Do your Due Diligence: with total alignment between you and the investor. Don’t get tricked in by overvaluation.
Anytime you engage with an investor, be aware of the risks. Despite the rhetoric, it is still an adversarial position The more strength you have built up before engaging with them, the better off you will be.
— — — — — — — — — — — — — — — — — — — — — — — — — — — — — —
Dr. Rajiv Tandon is executive director of the Institute for Innovators and Entrepreneurs and an advocate for the future of entrepreneurship in Minnesota. He is an adviser to fast growth Minnesota CEOs. He can be reached at email@example.com.